Covid-specific inflationary pressures are dominant and are transitory

There has been some very interesting data and other research published recently that allow us to more fully understand what is driving the current inflationary pressures. There is a massive lobby now pushing the idea that the central bank bond-buying programs and the rising fiscal support during the pandemic are responsible. This sort of narrative is coming from the mainstream economists who are suffering attention-deficit disorders (even though they get the top platforms all the time to preach their views), and, who in the last few weeks have become increasingly vehement and personal in their attacks on Modern Monetary Theory (MMT). Their actions are a sign that the cognitive dissonance is getting to them and they realise they have been left behind. But the evidence that is continually coming out across a number of indicators continues to reaffirm my view that the current inflationary spikes are being driven by the total abnormal circumstances the world has found itself in as a result of the pandemic. The usual institutional and structural drivers of an inflation – which were certainly prominent in the 1970s – seem to be absent at present. I will present further research next week on this topic as I build further evidence.

ECB admit interest rates rises do not work

The ECB conducted a Twitter Q&A yesterday (February 10, 2022) with Executive Board member Isabel Schnabel answering the questions.

Several answers were telling.

1. “Inflation has risen mainly due to energy prices which we cannot affect directly. But we are seeing that inflationary pressures are broadening and becoming more persistent. Policy optionality is therefore more important than ever.”

2. “If there is a risk that inflation expectations become unanchored, we need to take action even if the shock is exogenous. Currently, longer-term inflation expectations remain well-anchored.”

3. “Due to lags in policy transmission “transitory” shocks typically do not require policy action. They matter for monetary policy when there is a risk that they become entrenched in expectations, requiring policy action to protect price stability.”

4. There was this interesting exchange:

5. “ECB simulations show that the stock of assets acquired under APP and PEPP will put sizeable downward pressure on interest rates across the maturity spectrum for the years to come.”

6. “In the 1970s rising oil prices triggered a harmful price-wage spiral, as inflation expectations drifted away. Today longer-term inflation expectations are well-anchored. We will ensure that high inflation does not become entrenched.”

7. “The empirical link between money growth and inflation has weakened over recent decades. Inflation developments depend on the transmission of policy measures to the real economy, which hinges, for example, on the state of the banking sector.”

8. “Raising rates would not lower energy prices. But if high current inflation threatens to lead to a de-anchoring of inflation expectations, we may still need to respond, as our mandate is to preserve price stability.”

9. “What matters for inflation is the growth in wages over and above productivity growth. We carefully monitor wage developments as they are crucial for the inflation outlook”.

So what you get from all that is effectively what I have been writing about for the last year when I discuss inflation.

Interest rate increases are not appropriate when OPEC is using its cartel power, or workers are sick from Covid and cannot deliver or produce goods and services, or lockdowns stop service purchases and boost goods purchases and the supply-side cannot respond quickly enough.

The following graph shows the long-term inflationary expectations from the – ECB Survey of Professional Forecasters First quarter of 2022.

The long term inflationary expectations (for 2026) have risen over the course of the pandemic but are still below 2 per cent (1.97 per cent in January 2022).

There is no break-out evident.

This graph (taken from Chart 4 of the ECB SPF) reinforces that conclusion. It shows the distribution of the point estimates of inflation across the survey group.

The concentration between 1.8 per cent and 2.0 with a shift towards 2 over the last 3 quarters tells me that this group is not forecasting an inflation outbreak over the next 4 years.

I can also note that the Euro 5-year, 5-year inflation swap rate has been declining recently, which also accords with what is happening in the US.

Speaking of which – here is the graph for the ‘5-year, 5-year forward inflation expectation rate’ in the US (daily data) which measures “expected inflation (on average) over the five-year period that begins five years from today”.

The data runs from January 2003 to yesterday, February 9, 2022.

The series most recent peak was on October 15, 2021 (2.41 per cent) and has been on a consistent downward trend as the nature of the current price pressures becomes more obvious.

I caution though.

In its July 2006 Monthly Bulletin article – Measures of Inflation Expectations in the Euro Area – the ECB noted that:

Inflation-linked swap quotations are an additional source of information about market participants’ inflation expectations … The resulting inflation-linked swap rates should, therefore, not be interpreted as direct market expectations of future inflation rates.

There is also mixed survey evidence.

So at least in Europe and the US, there is no breakout of inflationary expectations, which might drive the supply constraints into a generalised inflation.

So this part of the story looks to support the transitory, supply-side interpretation, I have been offering for more than a year now.

The labour market

The European Commission conducts regular – Business and consumer surveys – and one of the questions they ask business firms relate to “Factors limiting production”.

In their – January survey – they found:

Reports on shortage of material and/or equipment as a factor limiting production climbed to the highest quote on record (+3.6pp to 50.8% of all industry managers). These production constraints are compounded by shortage of labour force, with a record 25.9% (+2.4pp compared to October) of managers identifying labour shortages as a limiting factor for production …

Capacity utilisation in services decreased …

They produced this graph (Graph 11 EU Capacity Utilisation) which tells me that there is still excess productive capacity available across European firms – which, in turn, tells me that this is not a demand-driven price episode.

Further, I consulted the most recent data for ‘negotiated wage rates’ for the Euro area, which gives a good indication of wage pressures coming from organised labour bargaining.

Refer back to Isabel Schnabel’s answer (quote 9 above) about ‘what matters for inflation’.

Data is available from the Eurostat and the ECB (Source) from the March-quarter 1991 to the September-quarter 2021.

Here is a graph of the annual growth in negotiated wages.

To help you understand the implications, I repeat what I have often written.

If labour productivity growth is growing at say x per cent per annum (which reduces unit labour costs) then nominal (money) wages can grow by the same rate without putting any cost pressures on the rate of inflation.

Average labour productivity (output per hour) has been 2.2 per cent over the period March-quarter 1995 to September-quarter 2021. Over the 12 months to the September-quarter 2021 it averaged 4.5 per cent (Source).

So using the long-term average as a guide to discern the available inflation-free headroom for wages growth, and, given the ECB is targetting a 2 per cent inflation rate, then wages can grow at around 3 to 4 per cent per annum without there being any significant inflationary impacts.

The graph shows that not only is the rate of growth in negotiated wages falling, it is now down to 1.36 per cent, which means that not only are real wages falling (hardly a sign of a demand boom) but the gap between productivity growth and wages growth is rising.

Again, experts look at this data and conclude there is not a demand-side (overspending) dynamic driving the inflation trajectory.

The supply constraints

The San Francisco Federal Reserve Bank conducts very interest – Economic Research – and one of the current projects is to study the – Inflation Sensitivity to COVID-19.

They provide decompositions of the growth in US inflation (core personal consumption expenditure – PCE – measure) that can be traced:

… to the economic disruptions caused by the pandemic.

They write that the “PCE measure of U.S. inflation is considered particularly useful for identifying underlying inflation trends.”

It excludes the short-run volatility coming from “food and energy products”.

They calculate “sensitive and insensitive components”, where:

COVID-sensitive components include those categories where either prices or quantities moved in a statistically significant manner at the onset of the pandemic, between February and April 2020. COVID-insensitive components include all other core PCE categories.

They produced this really interesting graph (Chart 1 from the FRBSF research).

The interpretation is pretty clear.

Inflation is being driven by Covid-specific effects and when they are attentuated (if) then what is left is low and pretty stable inflation.

They also present a breakdown of the Covid sensitivity into demand and supply components, which I will write about another day when I have more time.

You can learn more about this research from:

Shapiro, A. (2020) A Simple Framework to Monitor Inflation, FRB San Francisco Working Paper 2020-29.


I am maintaining my view that the current inflationary spikes are being driven by the total abnormal circumstances the world has found itself in as a result of the pandemic.

The usual institutional and structural drivers of an inflation – which were certainly prominent in the 1970s – seem to be absent at present.

So the assessment – Transitory – remains.

And repeating, that doesn’t mean short-term. Transitory means as long as the special circumstances are present.

The risk is the longer it takes to resolve the pandemic, the more likely some of those institutional and structural forces might emerge. I doubt it though.

Our edX MOOC – Modern Monetary Theory: Economics for the 21st Century continues

We are off and running again for another year with the first day of our MMTed/University of Newcastle MOOC – Modern Monetary Theory: Economics for the 21st Century.

The course is free and will run for 4-weeks with new material each Wednesday for the duration.

It is not to late to enrol and became part of the already large class.

Learn about MMT properly with lots of videos, discussion, and more.

This year there will be some live interactive events offered to participants, which adds to the material presented previously.

So even if you completed the course last year, these live events might be a reason for doing it again.

Further Details:

If you want to do the course, get in early as then you avoid having to catch up.

All are welcome.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.